July 31, 2017

When a C corporation’s shareholder-employees are given generous salaries and benefits, the corporation should be prepared to fight IRS claims that some of the compensation payments are actually disguised dividends, which were paid according to stock ownership. Specifically, the IRS will argue that the corporation can’t justify compensation amounts that exceed what’s ordinarily paid by similar companies to workers who supply similar services. This is referred to as the reasonable compensation test.

When allegedly excessive amounts of compensation and benefits are provided to an individual, the IRS will treat the excess as dividends. This can result in double taxation. Corporate taxable income is taxed once at the corporate level and again at the shareholder level when that income is paid out as dividends.

The right-hand box summarizes two U.S. Tax Court decisions involving reasonable compensation. But first, we’ll cover some necessary background information.

Avoiding Double Taxation

In general, the easiest, best way to avoid double taxed dividends is to make deductible compensation payments to shareholder-employees and deductible payments for fringe benefits for those individuals. As long as such payments pass the reasonable compensation test, they can be used to reduce the corporation’s annual taxable income to zero — or at least to $100,000 or less, where the corporation’s average federal income tax rate is far below the current 28%, 33%, 35% and 39.6% marginal federal rates that typically apply at the shareholder-employee level.

How Much Can Be Justified as Reasonable?

In the real world, the reasonable compensation test is often not easy to apply to closely held companies. Shareholder-employees are often business founders who made big personal sacrifices over the years, were grossly underpaid in some years, and have been the driving force behind their company’s growth and profitability.

Reasonable Compensation Checklist

The following checklist summarizes some relevant factors to consider when determining how much compensation can be paid to a shareholder-employee while still passing the reasonable test.

“Yes” answers suggest reasonable compensation. “No” answers indicate the opposite. However, that doesn’t mean you can’t have some “No” answers. Each factor’s importance depends on the facts of the particular case. In other words, assessing reasonable compensation is more of an art than a science. That’s why the issue is frequently litigated.

Tax Motivation Factors

1. Would a hypothetical outside investor conclude that return on shareholder equity hasn’t been reduced to unacceptably low levels because of excessive compensation to shareholder-employees? Based on trends in court decisions, this so-called hypothetical outside investor standard now appears to be the single most important factor in assessing compensation reasonableness.

2. Is it clear that compensation levels aren’t determined simply by percentage of stock ownership?

3. Does the company have a history of paying at least some dividends? However, the mere fact that no dividends have been paid doesn’t by itself prove that compensation is unreasonable.

Company-Specific Factors

1. Are sales and profits healthy and growing?

2. Are key financial ratios favorable?

3. Is the company performing above average for the industry?

4. Is the nature of the business unique, difficult or highly specialized?

Employee-Specific Factors

1. Has the shareholder-employee demonstrated commitment by length of service and making measurable contributions in the past?

2. Does the shareholder-employee handle multiple functions (marketing, personnel, financial management, etc.) for one salary?

3. Does the shareholder-employee have extensive experience in the company’s line of business?

4. Does the shareholder-employee possess unique skills or education, or possess a unique “package” of attributes?

5. Is the workload of the shareholder-employee exceptionally high?

6. Are the fringe benefits (retirement plan, medical insurance, and so forth) paid to or on behalf of the shareholder-employee relatively modest?

7. Has the shareholder-employee been underpaid in the past? It’s well-established that large compensation increases can be justified if they’re intended to make up for significant undercompensation in earlier years. In other words, reasonable compensation is measured over a period of years rather than just one year at a time.

Compensation Policy Factors

1. Can the corporation document that it has established compensation policies and that they’ve been followed? In particular, year-end bonuses should be paid pursuant to written plans, and such plans should be followed consistently over the years. Large year-end payments are generally okay if the preceding advice is followed.

2. Was an outside advisor (for example, a CPA or compensation planning professional) engaged to design and oversee the bonus plan?

3. Can the company show that compensation levels for at least some non-shareholder-employees have been set using similar guidelines to those used to determine salaries for shareholder-employees?

Comparability Factors

1. Is there evidence that the compensation paid to the shareholder-employee is comparable to that received by employees rendering similar services to similar businesses? If favorable comparable salary data is available, it’s helpful to include it in your corporate minutes.

2. Is the shareholder-employee’s role with the company unique (meaning it’s unrealistic to compare this person to employees at other similar businesses)?

The Lesson

If you operate a profitable C corporation, passing the reasonable compensation test may be the key to avoiding double taxation. Your tax advisor can help you to document that compensation amounts paid to shareholder-employees pass the test.

© 2017